Large companies flush with cash have been repurchasing stock shares to boost share prices and provide shareholder value over the last few decades. Some investors view repurchases as a bad practice, while others view it as good for both the company and investors.
But which is it? As it turns out, stock buybacks have advantages and disadvantages for stock issuers and investors.
- Although they can provide benefits, stock buybacks have been called into question in recent years.
- There's been a significant rise in buybacks since 2000, with some companies looking to take advantage of undervalued stocks while others do it to boost their stock price artificially.
- Buybacks can help increase the value of stock options, which are part of many executives' compensation packages.
- Buyback programs can be easier to implement than dividend programs.
Why Do a Stock Buyback?
For corporations with extra cash, there are essentially four choices to make:
- The firm can make capital expenditures or invest in other ways into their existing business.
- They can pay cash dividends to the shareholders.
- They can acquire another company or business unit.
- They can use the money to repurchase their shares—a stock buyback.
Like a dividend, a stock buyback is a way to return capital to shareholders. A dividend is effectively a cash bonus amounting to a percentage of a shareholder's total stock value; however, a stock buyback requires the shareholder to surrender stock to the company to receive cash. Those shares are pulled out of circulation and taken off the market until they are reissued or dissolved.
Stock Buyback History
Before 1980, buybacks weren't all that common. However, they have become far more frequent recently. By 2019, U.S. businesses bought back $800 billion in shares ($600 billion after accounting for net equity).
As observed in the following graph from Yardeni Research, before 2004, there weren't many S&P 500 companies buying back stocks. Then, leading up to the Great Financial Crisis, buybacks skyrocketed to about $700 billion and crashed back to $100 billion in 2009. Buybacks then steadily rose again after recovering from the pandemic in 2020, reaching nearly $1.15 trillion in the first quarter of 2022.
Share Buyback Advantages
The theory behind share buybacks is that they reduce the number of shares available in the market and—all else equal—increase earnings per share (EPS) on the remaining shares, benefiting shareholders. For companies flush with cash, the prospect of bumping up EPS can be tempting.
In addition, companies that buy back their shares often believe:
- The stock is undervalued and a good buy at the current market price: Billionaire investor Warren Buffett utilizes stock buybacks when he feels that shares of his own company, Berkshire Hathaway Inc. (BRK.A, BRK.B), are trading at too low a level. However, Berkshire's directors have emphasized that they will only authorize repurchases at a price they believe to be well below intrinsic value.
- A buyback will create a level of support: During a recessionary period or market correction, buybacks are thought to create lower price levels that cannot be broken through.
- A buyback will increase share prices: Stocks trade in part based on supply and demand, and a reduction in the number of outstanding shares often precipitates a price increase. Therefore, a company can increase its stock value by creating a supply shock via a share repurchase.
- Buybacks increase the demand for a company’s shares: As a result, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly earnings per share (EPS) targets. All that said, buybacks can be done for legitimate and constructive reasons.
Stock Buyback Disadvantages
For years, it was thought that stock buybacks were entirely positive for shareholders. However, there are some downsides to buybacks. One of the most important metrics for judging a company's financial position is its EPS. EPS divides a company's total earnings by the number of outstanding shares; a higher number indicates a stronger financial position.
By repurchasing its stock, a company decreases the number of outstanding shares. A stock buyback thus enables a company to increase this metric without actually increasing its earnings or doing anything to support the idea that it is becoming financially stronger.
Starting in 2023, public company stock buybacks will be subject to a 1% excise tax, purportedly decreasing their attractiveness to businesses.
As an illustration, consider a company with yearly earnings of $10 million and 500,000 outstanding shares. This company's EPS, then, is $20. If it repurchases 100,000 of its outstanding shares, its EPS immediately increases to $25, even though its earnings have not budged. Investors who use EPS to gauge financial position may view this company as stronger than a similar firm with an EPS of $20 when in reality, the use of the buyback tactic accounts for the $5 difference.
Criticism of Stock Buybacks
The key reasons buybacks are controversial are:
- Artificial financial results: The impact on earnings per share can give an artificial lift to the stock and mask financial problems revealed by a closer look at the company’s ratios.
- Abuse: Companies can use buybacks as a way to allow executives to take advantage of stock option programs while not diluting EPS. However, there isn't much evidence supporting the widespread belief that this happens.
- Price bumps: Buybacks can create a short-term bump in the stock price that some say allows insiders to profit while suckering other investors. This price increase may look good at first, but the positive effect is usually temporary, with equilibrium regaining when the market realizes that the company has done nothing to increase its actual value. Those who buy in after the bump can then lose money.
Some economists and investors argue that using excess cash to buy up stocks in the open market is the opposite of what companies should be doing, which is reinvesting to facilitate growth (as well as job creation and capacity).
Buybacks vs. Dividends
As mentioned earlier, buybacks and dividends can be ways to distribute excess cash and compensate shareholders. Given a choice, many investors choose a dividend over higher-value stock; some rely on the regular payouts that dividends provide.
Therefore, companies might be wary of establishing a dividend program. Once shareholders get used to the payouts, it is difficult to discontinue or reduce them—even when that's probably the best thing to do. That said, the majority of profitable companies do pay dividends.
Buybacks benefit all shareholders to the extent that, when stock is repurchased, shareholders get market value plus a premium from the company. And if the stock price rises before the repurchase, those that sell their shares in the open market will see a tangible benefit.
Who Benefits From a Stock Buyback?
Companies benefit from a stock buyback because it can preserve stock prices, consolidate ownership, and take the place of dividends. Investors can benefit because they receive their capital back; however, a repurchase doesn't always benefit investors.
What Are the Disadvantages of a Buyback of Shares?
Starting in 2023, public companies will be required to pay an excise tax of 1% on buybacks. Stock repurchases can also falsely boost earnings per share without a corresponding earnings boost.
What Happens to Stock Price After a Buyback?
A stock buyback generally initiates a surge in price because there will be fewer available. Some investors might also help push the price up by purchasing stocks before the buyback, hoping to make a profit on the sale.
Why Would a Company Buyback Shares?
Companies generally buy back shares to consolidate ownership, increase their share price on the market, increase demand for their stock, or serve as a support level for stock prices if the market takes a downward turn.
The Bottom Line
Share repurchase programs have always had their advantages and disadvantages. But as their frequency has increased in recent years, the actual value of stock buybacks has come into question. Some corporate finance analysts feel that companies use them as a disingenuous method to inflate specific financial ratios, such as EPS, under the auspices of providing a benefit to shareholders. Stock buybacks also enable companies to put upward pressure on share prices by affecting a sudden decrease in supply.
Investors shouldn't judge a stock based solely on the company's buyback program, though it is worth looking at when you're considering investing. A company that repurchases its shares too aggressively might be reckless in other areas. In contrast, a company that repurchases shares only under the most stringent circumstances (unreasonably low share price, stock not very closely held) is likelier to have its shareholders’ best interests at heart.
You should also remember to focus on the stalwarts of steady growth, price as a reasonable multiple of earnings, and adaptability. That way, you'll have a better chance of participating in value creation vs. value extraction.